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May Value Contest Submission: R.G. Barry

Alex Morris

Alex Morris

36 followers
I was tipped off to this month’s contest submission from the Value Investing Congress notes compiled by Ben Claremon, an invaluable resource that I’m indebted to him for (check out his blog, The Inoculated Investor, here). The pick comes from Steve Leonard of Pacifica Capital Investments, whose firm is the largest shareholder of this particular company. Unlike PepsiCo (PEP), Berkshire Hathaway (BRK.B), and Johnson & Johnson (JNJ), this is a small cap with less than $125 million in annual sales (in FY 2010) and only 154 full-time employees, a nice change of pace from the large cap stocks I have pitched for the previous contests. Just to clarify, the VIC notes simply mention the name, and the fact that the company has outsourced to China to lower operating costs; beyond that notation from Ben, any research in this report is from my own due diligence and should be judged as such.

BUSINESS

R.G. Barry Corporation (NASDAQ: DFZ), based out of Pickerington, Ohio, is a developer and manufacturer of accessory footwear, including slippers, sandals, slippery socks, hosiery, hybrid and active fashion footwear, some of which is developed and sourced as private label footwear for some of North America’s leading retailers. Their products are predominantly sold in North America (company’s primary source of both revenues and cash flows) through department stores, chain stores and mass merchandising channels of distribution.

The company was founded in 1947, and operated a manufacturing-based business model for 57 years; in 2004, they implemented their current business model, which doesn’t involve the operation of any manufacturing facilities (all products sourced from overseas, along with R&D being relocated there in 2010). As noted in the 10-K, “Under our current model, we have recorded consistent profitability and increased net sales annually since 2005, a period that has included some of the most difficult retail seasons in decades.”

The company’s fiscal year ends in late June, which was changed in 2006 to simplify planning and financial reporting due to the fact that approximately 70% of their revenues are derived in the last six months of the year (holiday shopping). The company has noted that one of their corporate objectives is to acquire or to develop businesses that will add more seasonal balance to the annual business cycle (as you will see, this is why R.G. Barry is a value at $11 per share). Since 2006, in an effort to diversify from their core slipper business, the company has moved into sandals and fashion footwear, along with handbags and travel accessories, many of which are sold in retail channels not previously served by the company.

MANAGEMENT

The chief executive officer of R.G. Barry is Greg A. Tunney, who has held this position since May 2006. Since taking the helm at R.G. Barry, the company has had impressive operating results, with revenues, net earnings, and diluted EPS increasing at a rate of 6.16%, 17.9%, and 16% per annum, respectively. Prior to joining the company in early 2006, Mr. Tunney was the president and COO of Phoenix Footwear Group, a supplier of diversified apparel (including footwear, belts and sportswear) for seven years. The remainder of the executive team has widespread experience in the apparel industry, including former leadership positions at Limited Brands (LTD), Oakley, and New Balance.

Compensation is a good check of whether management is benefiting with you or in spite of you. Unfortunately for R.G. Barry, the executive team, and especially Mr. Tunney, appears to be overpaid. In 2010, for example, his total compensation exceeded $1.6 million, or more than 10% of pretax earnings; while this isn’t significant in absolute terms (compared to eight-figure salaries at Fortune 500 companies), it is substantial in relative terms. In addition, Mr. Tunney only held 42,529 shares at the time of the filing, or roughly 30% of his annual compensation (based on current share price). While he has done a great job in the past five years at R.G. Barry, it would be more convincing if he put a larger portion of his net worth along side shareholders.

SUPPLY CHAIN

R.G. Barry operates a sourcing office in Dongguan City, China, where the company purchases slipper-type products from fourteen different third-party manufacturers (all of whom are located in China). One product (Superga, which is a licensed) is sourced from third-party Vietnam-based suppliers who provide those same products to Superga’s parent company, BasicNet.

After third-party transportation delivers the products to the United States, the company has two distribution routes. The first is an independent third-party logistics provider located in southern California, which stores products, fulfills orders and distributes R.G. Barry’s products to customers. The second route is a leased distribution center in San Angelo, Texas, which primarily supports shipments of Terrasoles and Superga (two brands) and other replenishment, closeout product and e-commerce orders (case pack shipments to customers). Among these facilities, only the corporate headquarters is owned; the other properties are leased, with an approximate aggregate annual rent of $565,500.

FINANCIALS

As of April 2, the company had a strong balance sheet, with more than $63.5 million in current assets, compared to roughly $57 million in total liabilities (working capital ratio of 4.8:1). At this point last year, the balance sheet was even stronger, with more than $40 million in cash and equivalents; the reason this account has dried up is due to the acquisitions of Foot Petals, LLC and Baggallini, Inc. business operations (combined cost of $47 million after assumption of debt is accounted for); more on this later. As a result of recent business developments, cash flow in the near future (a good portion; I estimate at least 50%) will be spent on debt repayment (roughly $4 million per year through 2016) and regular dividend payments ($0.07/quarterly at the time of writing, suggesting a $3 million annual cost).

HISTORICAL RESULTS

During fiscal year 2010, the company increased sales by nearly 9% (compared with 2009), or $10 million, to $124 million. Pre-tax earnings were $15 million, equal to a pretax profit margin of 12.1%. For the year, net earnings (after tax) of $9.4 million were equal to diluted EPS of $0.85, an increase of more than 30% from 2009 EPS of $0.65. A historical 10-year review of the company would be misleading, because the change in business model has essentially created an entirely new entity; luckily for us, the past 5-6 years (since the change) has included both an economic boom and bust, which should provide us with an accurate view of the company’s operations through the business cycle. In the past five years (2005-2010), diluted EPS has jumped between $0.45 and $0.92 with an average in the range of $0.75-$0.80/share (2007 must be adjusted (reported EPS of $2.46) for tax benefit of $13.6 million due to the reversal of a deferred tax asset valuation allowance).

YEAR TO DATE RESULTS

The company reported third quarter earnings (ended April 2) this week, which provides us with up-to-date information for our analysis. Throughout the first nine months of the year, sales are essentially flat ($107 million versus $106 million), while net earnings are down 24% over the same time period (without adjusting for acquisition costs in the third quarter of this year). The biggest weakness in the quarter was footwear, which swung from a third-quarter operating profit of $718,000 in 2010 to a third quarter loss of $965,000 in 2011. This was largely driven by lower volumes (also the driver of a 9.4% overall sales decline in the quarter) to mass merchandisers and warehouse clubs, along with higher product costs paid to third party manufacturers. As noted on the call by the CFO, “The decline reflected the impact of not repeating a spring promotional footwear program this year in the warehouse club channel, and reflected also fewer shipments of replenishment slippers to our largest customer.”

Obviously, this is concerning since footwear is a key part of the business; are we talking about a short term slip, or is this a red flag to investors? Here is what Mr. Tunney had to say on the call: “In the replenishment business, we are right in the middle of a process of shifting our replenishment businesses that we have in place and what happens is every year to two years you have a replenishment business that needs to be refreshed, that needs to be brought in and we are right in the cycle of doing that. For those who have followed R.G. Barry in years past, there was a time when we did a switch-off with a couple of our different retailers and this is one of those seasons where we’re doing it. So I would tell you from a softness in the business, no, I don’t see that.”

VALUATION

As outlined above, the company has generated earnings power of $0.75-$.80 per diluted share (consistently around 10-11 million shares outstanding, but slowly increasing due to stock based compensation) since the new business model has been implemented. At the current price (time of writing, $11.48 per share), this suggests a P/E multiple of 14.3x-15.3x earnings; not a screaming buy. However, as mentioned above, the company spent nearly $50 million (as a reminder, we’re talking about a company with a market cap of $127 million) on the acquisitions of the Foot Petals LLC and Baggallini Inc. business operations; what adjustment should we make to account for their impact on the income statement?

FOOT PETALS, LLC

Foot Petals LLC, a Long Beach, Calif.-based developer and marketer of premium insoles and products for common footwear-related problems, was purchased in January of this year for $14 million in cash. At the time, R.G. Barry CEO Greg Tunney called the acquisition “a key element of R.G. Barry’s long-term growth strategy.” In addition, as discussed by CFO Jose Ibarra at the time of the deal, Foot Petal’s is cash flow positive, and would be immediately accretive to earnings.

BAGGALLINI INC.

On March 31, R.G. Barry acquired Oregon based handbag and travel accessory maker Baggallini Inc. for $33.8 million (also cash). While the company is private, some data was released at the time of purchase; for example, the company achieved an annual sales growth rate in revenues of 16% since 2006. Mr. Tunney had this to say at the time: "These additions will transform our business and our future… The face of R.G. Barry immediately changes from that of a one-dimensional, modest-growth slipper company to that of a multi-faceted, growing provider of functional, fashionable accessories.” One important note on both acquisitions: They have significant goodwill components. For example, with Baggallini, the company recorded goodwill of approximately $28 million; this should be deductible for tax purposes.

The question is what is the quantitative affect of this “transformation?” Here is what can be found in the 10-Q; for Foot Petals, “Net sales and net earnings were not significant in respect of the Company’s condensed consolidated statement of operations for the Nine-month reporting period ended April 2, 2011. Any proforma net sales and net earnings of the combined entity, were likewise not significant to any combined view of proforma Company condensed consolidated statements of operations for the nine-month periods.”

With Baggallini, the story is a bit different: while sales and earnings were not included in the nine month numbers, proforma sales would have been nearly $120 million (with net earnings above $11 million), compared to actual results of $106 million and $8.4 million for revenues and earnings, respectively. The same is true for proforma results through the first nine months of 2010, with sales and earnings increasing by $11 million and $2 million, respectively; clearly, Baggallini will have a material impact on R.G. Barry’s results once they are consolidated.

Why is this transformation so important? A look at the third quarter breakdown by segment operations can help explain why. Despite more than $17 million in footwear sales in third quarter 2011, the company reported an operating loss of nearly $1 million. Accessories (which is simply the two acquired businesses), on the other hand, had only $2.4 million in sales, yet reported $815,000 in operating profit; not only does this segment balance out the seasonal nature of the footwear operations (gift-oriented slipper products), but it can also drive sales and cash flow in the quarters that footwear lags. With $30 million in net sales (historical) between the two businesses and targeted net growth of 10% looking ahead, these are material additions to R.G. Barry, and will cause revenues and net income to pop in the coming years.

On the company’s conference call from Wednesday, May 11, management dug deeper into the acquisitions and what they mean for R.G. Barry:

“The additive nature of new businesses should increase consolidated revenue for fiscal 2012 to around $140 million. Consolidated gross profit, which has traditionally been targeted around 40% of net sales, is modeled to rise to around the mid-40s. We will achieve this by restoring our footwear gross profit to around its traditional level, and then layering on the much richer margins from our new accessories segment. Consolidated operating profit is expected to increase from our traditional range of 10-12% of net sales to the mid-teens.” To clarify, this forecast accounts for businesses that management is currently exiting, which have annual revenues of $10-12 million; a back of the envelope calculation shows 2010 revenue ($123) – divestitures ($12) + acquisitions (historical $30) is already at $140 million, assuming now growth. If management can even put up these numbers (the $140 figure), we’re looking at operating profit in excess of $20 million per annum, compared to a range of $10-14 million over the past couple of years.

RISKS

My two biggest concerns would be the “dirty bomb” type risks, the first of which is the nature of production and the supply chain. From the 10-K: “Our overall experience with third-party manufacturers has been very good in terms of reliability, delivery times and product quality. All of our purchases in China are conducted on an open account basis. We recognize, however, that reliance on third-party manufacturers does carry elements of risk. During fiscal 2010, we did not experience any substantial adverse quality or delivery issues. We will continue to ensure that the sourcing activities supported by our Dongguan office are effectively aligned to ensure that the quality and delivery of products complies with our and our customers’ standards. We are dependent on methods of third-party transport to move our products from our third-party manufacturers to our distribution facilities, and from those facilities to our customers.” An important side note is that the company has a section in the 10-K which discusses their dedication to ethical business operations; they, along with key customers, conduct human rights and supplier audits, and “demand the highest business and personal ethical standards.”

Another issue is dependence upon a few large customers, as noted in the 10-K: “Walmart Stores Inc. and its affiliates accounted for 35%, 38% and 37% of our consolidated net sales during fiscal 2010, fiscal 2009 and fiscal 2008, respectively. Our sales to Walmart Stores Inc. (WMT) and its affiliates are less seasonal in nature than those to many of our other customers. J.C. Penney Company Inc. (JCP) accounted for 10%, 10% and 11% of our consolidated net sales during fiscal 2010, fiscal 2009 and fiscal 2008, respectively.” Obviously, the loss of any of these key customers would have a material effect on the business; however, the fact that they have done business with these two companies for a substantial period of time (mentioned in 2000 10-K) should suggest some stability in the relationship.

CONCLUSION

The value proposition is as such: The company has consistently earned (on average) $0.75-$0.80 in diluted EPS since 2005. In this quarter, Foot Petals and Baggallini delivered nearly $1 million in operating profit; on an annualized basis, there is no reason to believe that this division can’t deliver $2-3 million in additional profit to R.G. Barry’s bottom line; despite the tax benefits from goodwill, let’s assume they pay a full 35% on those profits, good for an after tax benefit of $1.3-$1.95 million (based on conservative measure assuming no growth and no tax benefits). When we take that on a per share basis (based on 11 million currently outstanding diluted shares), we get an additional $0.12-$0.18 per share in EPS, moving our range for earnings power closer to $0.90-$1; essentially, you can buy R.G. Barry, which has current assets worth more than total liabilities, for 11-13x our conservative estimate of earnings power in a tough retail environment and assuming no growth; when we look at the acquisitions discussed above, I believe that is a pessimistic and unrealistic expectation for the future. As noted by Mr. Tunney on the call, “we entered this year as a one-dimensional, modest growth slipper company; we will leave fiscal 2011 as a multi-dimensional growing provider of functional fashionable accessory products.” While you sit and wait for the changes to take hold in the business, R.G. Barry pays a dividend with a current yield of 2.44%; based upon these conclusions, I believe that R.G. Barry Corporation is a conservative value investment at less than $11.50 per share.

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

Rating: 3.9/5 (18 votes)

Comments

John Emerson
John Emerson - 3 years ago


One thing you have to watch closely when purchasing companies which outsource from China is the dollar/yuan relationship. As the yuan is allowed to rise so does the COGS for the US company which purchases the goods. As the dollar weakens against the yuan the gross margins are likely to contract. If China decides to float their currency at some point to deal with inflation, the result would be a temporary disaster until a better deal can be found in another cheap manufacturing country.

The current weak dollar policy in the US is much more favorable for US multinationals which sell into stronger currencies. Just something to keep in mind.
Alex Morris
Alex Morris - 3 years ago
Great point John; this actually happened to the company (to some extent) in fiscal 2009, which caused gross profit margin to dip to 38.2% (from the low 40's on average). The question for me is, how would this affect the competition? In the footwear space, competitors (although not direct, a good proxy for the industry) are in a similar situation: Steve Madden (SHOO) is pushing production to Northern China, and Brown Shoe Company (BWS) sourced 98% of their production from China last year. In the scenario described, what would be the outcome? I certainly assume that prices would increase; the company's slippers range from $5-30, so even a 10-20% increase isn't a deal-breaker for the consumer. Still, as noted, this is something to watch for; thanks for the comment John.
kfh227
Kfh227 premium member - 3 years ago
Pre 2006, FCF is red every year. Post 2006 every year is black. Seems that the new plan is working. TTM is $30 million or so.

Why is the share count continually increasing?

What brands? Anything well known?

Anything on the board of directors? I worry about family and friends in smaller companies. Yes, I have seen what were basically friends at some small companies.

My 1 minute valuation (FCF based) puts this companies value at around $200 million. Maybe a little more but that share count thing irks me. If you ignore the high and low 'recent' Fcf numbers though, that number is more like $150 million.

So, for this to be bought with a margin of safety, there need to be good reason to see FCF going up to $20 million a year and staying there. Based on revenues, that could be tough. There is still that issue of shareholder dilution (shares increasing) too.

Foot Petals was bought for $14 million. What does that company represent in revenue terms? Same question for Baggalini.

Strong balance sheet! Any time I see no long term debt and positive shareholder equity I smile.

Thanks for bringing this one up!

Alex Morris
Alex Morris - 3 years ago
Kfh227,

Let me try and go through this one by one:

1. 196,000, 174,000, and 208,000 shares RSU's vested and stock options exercised in 2010, 2009, and 2008, respectively. Without any buyback, that is why you're seeing the count increase.

2. "Dearfoams is our principal proprietary brand. Since its introduction in 1958, Dearfoams has, according to our own consumer research, become one of the most-recognized brand names in accessory footwear. Several basic slipper profiles are standard in the Dearfoams brand line, its sub-brands and our other proprietary and licensed slipper brands." - I'm not big on slipper brands, so I would have to take their word for it; regardless, don't know many people who feel a big connection to their brand of slippers (but I could be wrong).

3. I saw no issues with the board, and didn't discuss it under management for that reason (should have put a line or two - sorry about that); I'm trying to post the link, but giving me trouble (which is why you see three deleted comments above this one!). Go to sec.gov and look at the 14A filed last year for the most recent discussion of the board members and their experience.

4. They didn't breakout the revenue by acquisition; $30 million total is what they bring to the table, with management's expectations of 10% per annum over the coming years.

As I noted above (and what you're saying too), the one issue is compensation; I pointed to Mr. Tunney's overall pay, which encompasses the options and RSU's. At the current pace, these two forms of compensation are adding 1.8% to shares out every year (just to put it in numbers).

Thanks for the comment! Feel free to ask anything else that comes to mind.
Adib Motiwala
Adib Motiwala - 3 years ago
TTM FCF was $10 million (OCF was $11.5 million). I do not consider this stock under valued based on its historical numbers and FCF track record. Maybe, if it was available for $100 million it would be interesting.
kfh227
Kfh227 premium member - 3 years ago
thanks,

1) That was my assumption. thanks for the verification.

2) My favorite slippers are my funny Homer Simpson ones. Cheap and junky but super warm in the winter.

Dearfoams has some nice mens slippers!

http://www.dearfoams.com/

3) Thanks! I'll try to get to that soon

4) I hope that the growth assumptions are accurate.

THANKS!
Adib Motiwala
Adib Motiwala - 3 years ago
See this news. Coach (COH) plans to cut manufactuing in China by 50% over the next 5 years.

http://www.ft.com/cms/s/0/e01b1796-7cb6-11e0-994d-00144feabdc0.html?ftcamp=crm/email/2011513/nbe/USBusiness/product#axzz1M79jhu1V

Alex Morris
Alex Morris - 3 years ago
Adib,

I understand what you are saying, but you have made no adjustment for the two acquisitions, a HUGE change for their business. Based simply on what you said (Maybe, if it was available for $100M it would be interesting), don't forget they spent $47 million in cash; so if you take away the two acquisitions, you would be willing to pay $147M for this company? At $127M, it is currently 16% below that price. Not a huge margin of safety, but looks good from OCF; let me know if you have any additional thoughts on this.

Kfh227,

As I noted above, their revenue estimate for FY2012 doesn't even show any growth for those two businesses: 2010 revenue ($123) - divestitures ($10-12, use 12) + acquisitions (historical $30) = $141, assuming no growth.



Alex Morris
Alex Morris - 3 years ago
Adib,

Remember what Coach is selling and at what prices (when I went to the website, the average pair of sandals is around $200), versus what R.G. Barry is selling and at what price (slippers in the $5-30). I think the demand for these two products (partly due to their pricing) isn't as comparable as many think, and would react quite differently to input cost increases (I don't think most people would walk away from the slippers purchase solely because they are $6 instead of $5).
Adib Motiwala
Adib Motiwala - 3 years ago
Alex,

However, that is cash they spent. Can you point towards the incremental FCF or EBIT or ROC due to the two acquisitions ?

thanks

Adib
Alex Morris
Alex Morris - 3 years ago
Adib,

That was exactly my point; you pointed to TTM FCF, which is not a fair representation of the economic reality due to the two acquisitions. If you are going to use the updated balance sheet (which obviously you are right in doing so), you must look at what they spent that nearly $50M on.

They have suggested $30M in historical sales from the two additions (in aggregate, they have not broken them out individually), with 5yr historical CAGR in sales of 15-16% and 19-20% at Foot Petals and Baggallini, respectively, growth rates they expect to continue. Here is what they had to say for modeling numbers on the call:

My Notes:

1. Expect 20-25% gain in revenue in FY2012, up to $145-150M (they've been more conservative since, which was explicitly stated on the call, and stepped down to $140M); also expect margins to increase (due to characteristics of acquired businesses).

2. Gross profit estimation – historically low 40's, expectation is mid 40’s

3. Operating profit (EBIT margin) – historically 10-12% of net sales, hopefully rising to mid-teens

So the math suggests at an EBIT margin of 13-15% and sales of $140M-$150M that operating profit should land in the $18.2M to $22.5M range (using those assumptions).

Let me know if there are any questions on the EBIT figures. Thanks!

Please leave your comment:


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